Chapter Two

Corporate Valuation
Overview
When we discuss the valuation of a company, we may be referring to any of the following:
• Enterprise value: Valuing the company’s productive activities.
• Equity: Valuing the shares of a company, whether for the purpose of buying or selling a single
share or valuing all of the equity for purposes of a corporate acquisition.
• Debt: Valuing the company’s debt. When debt is risky, its value depends on the value of the
company that has issued the debt.
• Other: We may want to value other securities related to the company for example, the firm ’ s
warrants or options, employee stock options, etc.

2.1 Methods to Compute Enterprise Value (EV)

The key concept in corporate valuation is enterprise value. The enterprise value (EV) of the firm
is the value of the firm’s core business activities and forms the basis of most corporate valuation
models. We distinguish between four approaches to computing the enterprise value:
The accounting approach to EV moves items on the balance sheet so that all operating items are
on the left-hand side of the balance sheet and all financial items are on the right-hand side.
Although most academics sneer at this approach, it is often a useful starting point for thinking
about the enterprise value.
• The efficient markets approach to EV revalues to the extent possible items on the accounting
EV balance sheet at market values. An obvious revaluation is to replace the firm’s book value of
equity with the market value of the equity. To the extent that we know the market value of other
firm liabilities debt, pension obligations, etc.—this market value will also replace the book
values.
• The discounted cash flow (DCF) approach values the EV as the present value of the firm ’ s
future anticipated free cash flows (FCFs) discounted at the weighted average cost of capital
(WACC). The FCFs can best be thought of as the cash flows produced by the firm ’ s productive
assets—its working capital, fixed assets, goodwill, etc.
• In this book we use two implementations of the DCF approach. These approaches differ in their
derivation of the firm’s free cash flows.
2.2 Using Accounting Book Values to Value a Company: The Firm’s Accounting
Enterprise Value
While we would rarely use accounting numbers to value a company, the balance sheet of a
company is a useful starting framework for the valuation process. In this section we show how
accounting statements can help us define the concept of enterprise value (EV).
For illustration let’s consider the following balance sheet.
CTERPILLAR CORP. BALANCE SHEET
Current assets Current liabilities
Cash and cash 3,057,000 Accounts payable 16,946,000
equivalents
Short term Short-term debt 9,648,000
investments
Net receivables 19,533,000 Other current liabilities 1,967,000
inventory 14,544,000 Total current liabilities 28,561,000
Other current assets 994,000
Total current assets 38,128,000 Long-term debt 24,944,000
Long-term 13,211,000 Other liabilities 14,539,000
investment
Ppe 14,395,000
Good Will 7,080,000 Minority interest 46,000
Intangible Assets 4,368,000 Total liabilities 68,090,000
Other assets 2,107,000
Deferred Long Term 2,157,000 Stocks, options, warrants 473,000
Assets
Common stock 4,273,000
Retained earnings 25,219,000
Treasury stock -10,281,000
Other stockholder equity -6,328,000
Total equity 13,356,000
Total Assets 81,446,000 Total equity and liabilities 81,446,000

To get to the enterprise value balance sheet for Caterpillar, we move financial items from the left
side of the balance sheet to the right, and we move operating current liabilities from the right side
of the balance sheet to the left. Notice that we netted out liquid assets (cash and marketable
securities) from the financial debts of the company. The assumption is that these assets are not
needed for the core business activities of Caterpillar. The book value of Caterpillar’s enterprise
value is $59,476,000:
N.B:

Net Financial Debt = short term debt+ long term debt + cash and cash equivalents

Net working capital = note receivables + inventory + other current assets- account payable-
other current liabilities
 A B C D E F
1 CATERPILLAR CORP., 2011 ENTERPRISE VALUE BALANCE SHEET( Book values)
2 Networking 16,158,000 <…19533000+1454 Net 31,535,000 <--
capital 4000+994000- financial =9648000+24944000-
16946000 debt 3057000
-1967000
3 Long-term 13,211,000 Other 14,539,000
investments liabilities
4 ppe 14,395,00
5 Good will 70,080,000 Minority 46,000
interest
6 Intangible 4,368,000
assets
7 Other assets 2,107,000 Equity 13,356,000
8 Deferred 2,157,000
long-term
asset charges
9 Enterprise 59,476,000 <-- =SUM(B2:B8) Enterprise 59,476,000 <-- =SUM(E2:E7)
value value

2.3 The Efficient Markets Approach to Corporate Valuation

The Caterpillar example above assumes that the book value is a correct valuation of the
company. But a simple calculation shows how problematic this is:
At the end of 2011 Caterpillar had 624.72 million shares outstanding, and the market price per
share was $90.60. This suggests that the Caterpillar’s enterprise value is $102.720 billion—a far
cry from the book value of the enterprise value of $59.476 billion.
A B C
1 CATERPILLAR VALUATION OF EQUITY AND FINANCIAL LIABILITIES:
EFFICIENT MARKETS APPROACH
Most figures in thousand $
2 Number of share outstanding 624,722.72 <-- thousand shares
3 Price per share 90.60 <-- 30Dec2011
4 Equity value 56,599,878 <-- =B2*B3, thousand $
5
6 Cash and cash equivalents 3,057,000
7 Short term debt and current position of 9,648,000
long term debt
8 Long term debt 24,944,000
9 Net debt 31,535,000
10
11 Other liabilities 14,539,000
12
13 Minority interest 46,000
14 Preferred stocks 0
15 Enterprise value: Equity + Net debt + 102,719,878 <--
Minority Interest + Preferred stocks =SUM(B4,B9,B11,B13)
16

2.4 Enterprise Value (EV) as the Present Value of the Free Cash Flows: DCF “Top
Down” Valuation

In the previous section we valued the EV by using the market value of the right-hand side of the
firm’s enterprise value balance sheet—using the market value of its equity and perhaps the
market valuation of other elements of the firm’s financing. In this section we concentrate on the
left-hand side of the enterprise value balance sheet. The discounted cash flow (DCF) method
focuses on two central concepts:

• The firm’s free cash flows (FCFs) are defined as the cash created by the firm’s operating
activities.

• The firm’s weighted average cost of capital (WACC) is the risk-adjusted discount rate
appropriate to the risk of the FCFs

• The firm’s enterprise value (EV) is the present value of the future FCFs discounted at the
WACC:
N
FCFt
EV = ∑ ( 1+WACC ) t
t =1

The idea is to value a company by considering the present value of the FCFs, where FCF is
defined as the cash flow to the firm from its assets (the word assets is used broadly, and can be
fixed assets, intellectual and trademark assets, and net working capital). The next subsection
discusses this concept in more detail.

• In these chapters we often make two additional assumptions: We assume a limited number of
predictive periods for the FCFs and we assume that cash flows occur throughout the year. This
leads to
N N
FCFt Terminal value
EV= ∑ + ∑ ( 1+WACC
t =1 ( 1+WACC ) t−0.5 t =1 ) N−0.5
N

=¿+ ∑ Terminal value

(1+WACC ) N
)+ (1+WACC)0.5
t =1
The assumption that, for valuation purposes, cash flows occur approximately in mid-year is
meant to capture the fact that most corporate cash flow occur throughout the year and that it is
therefore a mistake to value them as if they occur at year-end. As can be seen from the above
formula, the mid-year assumption is easy to compute in Excel: We simply take the Excel NPV
and multiply it by (1 + WACC) 0.5

Defining the Free Cash Flow (FCF)

The free cash flow (FCF) is a measure of how much cash is produced by the firm’s operations.
There are two accepted definitions of the FCF (both of which, of course, ultimately boil down to
the same thing). Free Cash Flow Based on the Income Statement

Profit after taxes: This is the basic measure of the profitability of the business, but it is an
accounting measure that includes financing flows (such as interest), as well as non-cash expenses
such as depreciation. Profit after taxes does not account for either changes in the firm ’ s working
capital or purchases of new fixed assets, both of which can be important cash drains on the fi rm.

Depreciation and other non-cash expenses: Depreciation is a non-cash expense that in the FCF
calculation is added back to the profit after tax. To the extent that there are other non-cash
expenses in the firm’s income statement, these are also added back.

Increase in operating current assets: When the firm’s sales increase, more investment is
needed in inventories, accounts receivable, etc.. This increase in current assets is not an expense
for tax purposes (and is therefore ignored in the profit after taxes), but it is a cash drain on the
company. When adjusting the FCF for current assets, we take care to not include financial
current assets that are not directly related to sales such as cash and marketable securities.

Increase in operating current liabilities: An increase in the sales often causes an increase in
financing related to sales (such as accounts payable or taxes payable). This increase in current
liabilities—when related to sales— provides cash to the fi rm. Since it is directly related to sales,
we include this cash in the free cash flow calculations. When adjusting the FCF for current
liabilities, we take care to not include financial current liabilities that are not directly related to
sales: changes in short-term debt and the current portion of long-term debt being the most
prominent examples−

Increase in fixed assets at cost (CAPEX): An increase in fixed assets (the long-term
productive assets of the company) is a use of cash, which reduces the firm’s free cash flow.

After-tax interest payments (net): FCF is an attempt to measure the cash produced by the
business activity of the fi rm. To neutralize the effect of interest payments on the firm’s profits,
we:

• Add back the after-tax cost of interest on debt (after-tax since interest payments are tax-
deductible),
• Subtract out the after-tax interest payments on cash and marketable securities.

How Can We Predict Future FCFs?

The most critical aspect in valuing a company is to project its anticipated future free cash flows.
In this book we explore two ways of deriving these cash flows. Both methods are primarily
based on accounting data. Since accounting data is historical data, we need to add some
judgment about how this data will develop in the future.

• One method is to base our estimates of future free cash flows on the consolidated statement of
cash flows (CSCF) of the firm

• The second method is to estimate a set of pro forma financial statements for the firm and to
derive the free cash flows from these statements). Both methods are briefly y reviewed in
succeeding sections.

2.5 Free Cash Flows Based on Consolidated Statement of Cash Flows (CSCF )

The consolidated statement of cash flows is part of every financial statement. It is the
accountant’s explanation of how much cash was generated by the business, and how this cash
was generated. The consolidated statement of cash flows (CSCF) is composed of three sections:
Operating cash flows, investment cash flows, and financing cash flows.

• We accept the operating cash flows as reported by the fi rm. • We carefully examine the
investment cash flows, leaving for the FCF the investment cash flows related to productive
activities and eliminating those investment cash flows relating to investment by the firm in
financial assets. • We do not count toward the FCF any of the financial cash flows. • In all cases
we are careful about whether specific items are one time or recurring, eliminating from
consideration the one-time items. • We adjust the totals of the adjusted CSCF numbers by adding
back net interest paid.

CSCF, Section 1: Operating Cash Flows

The operating cash flows adjust the firm’s net income for non-cash deductions to the income and
for changes in the firm’s operating net working capital. Because modern accounting statements
include many non-cash items, translating the firm’s accounts to a cash basis necessitates many
adjustments. A classic adjustment is to add back depreciation to the firm’s income: Since
depreciation is a non-cash charge on the firm’s income, it must be added back when making the
adjustment for cash. But depreciation is just the tip of the non-cash iceberg:

• When firms issue stock options to employees, the value of these options is deducted from the
firm’s income. The logic behind this—that in giving its employees options, the firm has given
them something of value which must be accounted for in its income statement—is impeccable.
But the actual charge for options is a non-cash deduction, and in the consolidated statement of
cash flows, it is added back.

• A firm’s income statements must reflect the decrease in goodwill (so-called “impairment”).
This impairment—the loss in economic value of an intangible asset that was purchased by the
firm is an economic loss to the firm’s shareholders. But it is not a cash flow loss, and in the
consolidated statement of cash flows it is added back.

• The list can include a large number of additional items, For purposes of computing the firm’ s
free cash flows, we can usually leave all the items in the operating cash flow section of the
CSCF.

SCF, Section 2: Investment Cash Flows

The second section of the CSCF includes all investments made by the fi rm. These investments
include both investments in securities and investments in operating assets of the fi rm.

• Investment in securities can refer to the sale or the purchase of securities held by the fi rm.
Investment in securities is not part of the firm’s free cash flows, which are intended to measure
solely cash flows related to the firm’s core business activities.

• Investments in fixed assets are usually related to the firm’s FCFs. For purposes of computing
the firm’ s free cash flows, we need to distinguish between financial investment cash flows (not
part of the FCF) and investment in assets used to produce the firm ’ s business income (part of
the FCF).

CSCF, Section 3: Financing Cash Flows

The last section of the CSCF deals with changes in the firm’s financing. For FCF purposes, we
can ignore this section.

2.6 Free Cash Flows Based on Pro Forma Financial Statements

Another way to project free cash flows is to build a set of predictive financial statements based
on our understanding of the company and its financial statements.